Valuation multiples: P/E, P/B, EV/EBITDA and free cash flow yield
Multiples compare a company's price with what it earns, what it owns or the cash it generates. They help tell whether something looks expensive or cheap, with nuances.
Knowing a company is good isn't enough: how much you pay for it also matters. A great company bought too expensively can be a bad investment for years. Valuation multiples relate the price to some measure of the business so you can compare.
P/E (price / earnings)
P/E = share price ÷ earnings per share
It tells you how many dollars you pay for each dollar of annual earnings. If a stock costs $200 and earns $10 per share, its P/E is 20. Conversely, its earnings yield is 1 ÷ 20 = 5%.
- Trailing P/E: using the last 12 months' earnings.
- Forward P/E: using the earnings analysts expect for the next 12 months.
A high P/E isn't bad in itself: it usually means the market expects earnings to grow a lot. A low P/E can be an opportunity or a sign the market expects trouble.
PEG: the growth-adjusted P/E
PEG = P/E ÷ expected annual earnings growth (in %)
A company with a P/E of 30 growing 30% a year has a PEG of 1; another with a P/E of 15 growing 5% has a PEG of 3. It helps compare companies growing at different speeds, though it depends on the estimated growth actually happening.
P/B (price / book value)
P/B = market value ÷ shareholders' equity
It compares the price with what the company is worth "on the books". It's useful for banks and insurers, whose business is their financial assets. For tech or brand companies, whose value lies in things the balance sheet doesn't capture well (software, brands, talent), it's usually not very useful.
EV/EBITDA
Enterprise value (EV) adds up what the whole business is worth to everyone financing it: the market value of the shares plus debt, minus cash.
EV = market value + debt − cash
Price / sales and free cash flow yield
- Price / sales (P/S): useful when the company isn't profitable yet, though it doesn't say whether it ever will be.
- Free cash flow yield: free cash flow ÷ market value. 5% means the company generates each year, in free cash, 5% of what it's worth on the market.
How to use multiples without fooling yourself
- Compare like with like: a bank, a tech company and a miner have very different normal multiples.
- Compare against its own history: is it more expensive or cheaper than its 5- or 10-year average?
- Think about growth and quality: a company growing fast with high margins deserves a higher multiple.
- Be wary of the very cheap: sometimes it's cheap for a good reason.
- Use several multiples: each one sees a part.
| Multiple | Best for | Watch out for |
|---|---|---|
| P/E | Profitable, stable companies | Falling earnings or one-off items |
| EV/EBITDA | Comparing companies with different debt | Companies that invest heavily (EBITDA ignores capex) |
| P/B | Banks and insurers | Tech and brand companies |
| P/S | Companies that aren't profitable yet | It says nothing about profitability |
| Free cash flow yield | Seeing the cash it generates | Years with very high or very low investment |
Test what you learned
1. A stock costs $150 and its earnings per share are $10. What's its P/E?
- 10
- 15
- 150
Show the answer
15. 150 ÷ 10 = 15.
2. What does enterprise value (EV) add up?
- Market value + debt − cash
- Sales + profit
- Assets − liabilities
Show the answer
Market value + debt − cash. It's what the business is worth to shareholders and lenders.
3. For which companies is P/B usually most useful?
- Tech companies
- Banks and insurers
- Companies with no assets
Show the answer
Banks and insurers. Their business is financial assets that the balance sheet reflects well.
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Everything in this section is educational: it explains how investing works, it doesn't tell you what to buy.